BHP board mulls mitigation as prices plummet

Elizabeth Knight

BHP Billiton chief executive Andrew Mackenzie is pedalling hard. Perched on the podium with his chairman Jac Nasser, Mackenzie told shareholders at yesterday's annual meeting about the company's prospects and achievements and the external forces that are conspiring against it.

The prices of three of the major commodities that underpin the company's profit performance are in free-fall.

History will judge the BHP Billiton board and management on the quality of their mitigation plan. In other words, how much cost cutting and productivity improvement this team can extract to offset the plunging price of Iron ore, coal and oil. Those shareholders who understand the dynamics of BHP and its sensitivity to commodity prices realise that the company will earn less in 2015 than it did in 2014.

They understand that while commodity prices were also falling in 2014, the downward trajectory was not as steep. Of course, the 2015 year has another seven months to run but over the past few months the rate of the fall, particularly in iron ore and oil, is greater.

The BHP Billiton management team did a stellar job last year of cutting costs and capital expenditure to finish the year ahead of 2013 in a profit sense.

But many of the big early gains on cost cutting have already been extracted. Thus each incremental cut gets harder to achieve.

Advertisement

So it is not a question of whether BHP Billiton's earnings will fall in 2015 - it's a question of how much.

Nasser and Mackenzie don't know the answer to this because they can't predict commodity prices with much more certainty that the analysts or the economists.

Iron ore, the commodity to which BHP Billiton's earnings are particularly sensitive, has fallen to five-year lows and is hovering at about US$70 a tonne - a price that even bear forecasters would not have predicted even a few months ago.

It is the reason the big Australian iron ore stocks, including BHP Billiton, Rio Tinto and Fortescue Minerals, were hammered on Thursday.

The all-important Chinese market isn't helping. Within hours of the BHP Billiton board saying China's growth rate should reach the lower end of its 7 to 7.5 per cent target his year, HSBC released a report on the country's manufacturing activity suggesting growth in China's factory sector had stalled in November.

Mackenzie, along with other mineral commodity producers, is powerless to influence China's growth position.

All that he can do is pull the levers that he has available to him. Thus there was plenty of emphasis on Thursday's address to shareholders on this work.

BHP Billiton had made higher-than-forecast productivity gains of US$2.9 billion, he said. "That means over the past two years we have now embedded more than US$6.6 billion of sustainable productivity gains. We were also more selective with our investments. This led to a reduction in capital and exploration expenditure to US$15.2 billion."

There is no doubt BHP is pedalling hard to extract the best returns, given the commodity cards it has in its hands.

It has a dividend policy that states it will not decrease the size of the payment, so the pressure is on.

Its decision to push up iron ore production has been criticised by some as queering its own pitch, as the flood of additional capacity it, Rio and Brazilian producer Vale has contributed to the fall in the price of the metal. BHP and Rio are all very low-cost producers of iron and and can therefore make a tidy margin on iron ore even at these prices. But they can't make as much profit.

The company has resisted pressure from a variety of sources, including Western Australian Premier Colin Barnett, to ease up on capacity, but the pleas have fallen on deaf ears. To do so would require collusion, the producers say.

The issue is particularly sensitive because as the iron ore price continues to tumble, the likelihood of smaller, higher-cost producers being forced out of business increases.

Nasser and Mackenzie were in defence mode yesterday.

"Our company is ready for this," Nasser said. "We have a very strong strategy of productivity, which allows us to follow this price down.

"I think we've been very clear that prices at these levels are what we've been expecting for the longer term."

Nasser also said expansions in iron ore by BHP in Western Australia had been "long pipeline" investments and they had been well flagged by the company. "They don't creep up on you."

So what is the prize for BHP Billiton shareholders, given no forecasters are anticipating much of an uptick in the prices of three of the four pillars in the business?

The most obvious is the demerger, which should be approved by shareholders in the first half of calendar 2015. That should provide a strong positive for existing BHP Billiton shareholders' total returns.

History has shown that demergers create value for shareholders more often than not and the board will be working on the theory that BHP Billiton is no exception. In general the two businesses born from a demerger will have a higher combined value.

Nasser also spoke of returning excess cash to shareholders consistently, predictably and in the most efficient way. However, he didn't nominate a time frame.